The End of Cheap Money
How Investors Can Position for Rising Interest Rates
Investing in the equity and fixed income markets can be greatly affected by many variables, but one force that can have a big impact in both markets is interest rates. A historical bellwether has been the 10-year Treasury note. Since the beginning of 2021, the yield on the 10-year Treasury has risen over 75 basis points (0.75%). How does this affect you and your portfolio?
Bonds and interest rates have an inverse relationship. When interest rates increase, the current bond prices in the marketplace will drop. Bonds with a shorter duration will be affected less than bonds with longer duration. Picture snapping a whip, whereas the shorter end will not move as much as the tail of the whip that will snap and move greatly. Many investors have gone for greater yield in this near zero interest rate environment by owning longer duration assets. When Treasury interest rates rise, it tends to also increase mortgage rates, business loan rates and causes price declines in the fixed income markets. Money becomes expensive. It becomes harder to raise, borrow or lend capital.
This creates a bigger hurdle for businesses to expand and spend, including hiring more workers. Higher borrowing costs negatively impact a company’s balance sheet, cash flow and profitability. It reduces how much that business is worth or what an investor is willing to pay for it, including that company’s stock.
Higher interest rates reduce the current value of future earnings as well. For growth companies that have low earnings now, but are expected to have large earnings many years in the future, the decline in company valuation (and stock prices) when interest rates are rising is more pronounced than for slower growing companies. Therefore, many of today’s popular growth and tech stocks could see large price/valuation declines if interest rates continue to rise.
When interest rates are extremely low, savings accounts and high-quality bonds give investors very miniscule returns, and so they are incentivized to seek out riskier investments and invest in equities and other assets that are expected to produce higher investment returns. All of this increased demand pushes up stock and high-yield bond valuations.
However, when interest rates are high enough, investors may not need to take on more risk to get decent returns from lower-volatility bonds and savings accounts, so people are less incentivized to seek out stocks and lower quality, high-yield assets. They can reduce their riskier asset exposure, which means less demand and therefore lower valuations for stocks and riskier high-yield assets.
Some companies that may underperform due to rising interest rates include REITs, utility companies, and others that have high borrowing needs. These firms plus high-dividend consumer staples and Master Limited Partnerships stocks that serve as bond substitutes can also suffer in a rising rate scenario.
While some sectors may lag, there can be others that do relatively well. Banks, brokerages and insurers can benefit from a higher interest rate. Many of these companies earn interest on their free-standing capital or can charge more to their borrowers. The uptick in interest rates will benefit the financial sector as they will be earning more than in a near zero-interest rate environment.
Here are a few ideas to consider for a rising interest rate outlook:
- Look to invest more in value stocks as opposed to pure growth stocks
- Reduce the long-term bond or bond fund allocation in current portfolio
- Reduce holdings in popular high dividend stocks owned as bond substitutes
- Shorten bond duration/Consider floating and adjustable-rate instruments
- Consider non-U.S. stocks and bonds in from countries with stable interest rates
- For borrowers, lock in still low interest rates on 15-year or 30-year home mortgages
We have had historic low interest rates for an extended period of time. As the 10-year Treasury yield has jumped in the last 3 months and may continue, it is time to consider the investment implications and adjust the asset mix as needed.